Question

I need an answer for this topic dated after Jan 2018. Thanks. The concept of spillovers and their impact on resources allocation, and the corrective actions needed (by government or by the private sector).

Answer 1

"Spillover cost," also known as "negative externality," is a term used to describe some loss or damage that a market transaction causes a third party. The third party ends up paying for the transaction in some way, even though it was neither the buyer nor the seller and had no part in the original decision. When there are spillover costs, the market is operating inefficiently, because neither the producer nor the consumer of a certain product is paying its full cost. The production or consumption cost of a certain item is now being shouldered not just by the principals, but also by third parties. Since manufacturers and consumers aren't paying the full amount for a certain product, that product tends to be overproduced, resulting in market imbalance, a higher level of production or consumption than society really wants. When goods are produced, they may create consequences that no one pays for. Such unaccounted-for consequences are called externalities. Because externalities are not accounted for in the costs and prices of the free market, market agents will receive the wrong signals and allocate resources toward bad externalities and away from good externalities. Good externalities are consequences that benefit society. However, because those benefits are not accounted for in the price of the good, the price is higher than it should be, and too little of the good is consumed and produced. Bad externalities harm society. However, because the costs of those externalities are not accounted for in the price of the good, the price is lower than it should be, and too much of the good is consumed and produced. In both cases, the market has failed to reach efficiency, because it has allocated resources and production without considering the externalities. Classic examples of bad externalities include industrial pollution and traffic congestion. Industrial pollution has harmful effects on people and the environment. Yet the cost of producing goods does not include the cost of dealing with the effects of pollution. This means that, in the free market, producers are responding to costs that are too low, and consumers are facing prices that are too low. More goods are produced and sold in the free market than should be, given the negative social effects of pollution. An example of good externalities is private home renovation. Renovation has a beneficial effect beyond the renovated home, because it increases property values in the neighborhood. But such benefits are not included in the home owners’ calculations in a free market, because their neighbors do not pay them to renovate. As a result, fewer home owners renovate in the free market than the beneficial social effects would justify.

Government has significant capacities that have been applied to counter market failure. Public goods can be produced by the government for the benefit of all citizens. Government can impose and collect taxes to pay for the goods so that no free riders or duty shirkers can sustain their behavior. The government can impose costs for negative externalities through taxes or fees on individual producers and consumers and encourage positive externalities through tax breaks or subsidies for the market agents. Monopolies can be regulated to limit price excesses or production can be encouraged through subsidies when a product has increasing economies of scale. Welfare services, including education, child care, elder care, and health care, are considered by many welfare theorists as sectors where markets fail. Suboptimal distribution of access to these services in free markets is most often at the heart of these arguments. Here the suboptimal outcomes may be that some citizens cannot access welfare services or that the welfare service levels available are not the same for all citizens. In place of markets, government can mandate or directly provide access for all citizens, and it can regulate or directly produce the desired level of service.